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MBA 6101: Financial Accounting Chapter 4: Analyzing and Interpreting Financial Statements Prof. Larry Louie

MBA 6101: Financial Accounting Chapter 4: Analyzing and Interpreting Financial Statements Prof. Larry Louie. Analysis Structure. Operating Return (RNOA) . The income statement reflects operating activities through revenues, costs of goods sold (COGS), and other expenses.

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MBA 6101: Financial Accounting Chapter 4: Analyzing and Interpreting Financial Statements Prof. Larry Louie

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  1. MBA 6101: Financial AccountingChapter 4: Analyzing and Interpreting Financial StatementsProf. Larry Louie

  2. Analysis Structure MBA 6101 Financial Accounting

  3. Operating Return (RNOA) • The income statement reflects operating activities through revenues, costs of goods sold (COGS), and other expenses. • Operating assets typically include cash, receivables, inventories, prepaid expenses, property, plant and equipment (PPE), and capitalized lease assets, and exclude short-term and long-term investments in marketable securities. MBA 6101 Financial Accounting

  4. Op vs. Nonop items for Income StmtGeneral Mills ($mils) MBA 6101 Financial Accounting

  5. Tax on Operating Profit Income tax is tricky since the income tax expense includes tax savings from net non-operating expenses, so add it back For General Mills: MBA 6101 Financial Accounting

  6. Operating Items in the Income Statement Op vs. NonOp Assets for General Mills MBA 6101 Financial Accounting

  7. Op vs. NonOp Liabilities and Equity for Gen Mills MBA 6101 Financial Accounting

  8. General Mills’ NOA MBA 6101 Financial Accounting

  9. General Mills’ RNOA and ROE MBA 6101 Financial Accounting

  10. Key Definitions MBA 6101 Financial Accounting

  11. Disaggregation of RNOA MBA 6101 Financial Accounting

  12. Net Operating Profit Margin (NOPM) • Net operating profit margin (NOPM) reveals how much operating profit the company earns from each sales dollar. • NOPM is affected by • the level of gross profit • the level of operating expenses • the level of competition and the company’s willingness and ability to control costs. MBA 6101 Financial Accounting

  13. General Mills’ NOPM • This result means that for each dollar of sales at General Mills, the company earns just over 11.4¢ profit after all operating expenses and tax. • As a reference, the median NOPM for all publicly traded firms is about 7 to 7.5¢ MBA 6101 Financial Accounting

  14. Net Operating Asset Turnover (NOAT) • Net operating asset turnover (NOAT) measures the productivity of the company’s net operating assets. • This metric reveals the level of sales the company realizes from each dollar invested in net operating assets. • All things equal, a higher NOAT is preferable. MBA 6101 Financial Accounting

  15. General Mills’ NOAT • This result means that for each dollar of net operating assets, General Mills realizes $1.05 in sales. • As a reference, the median for all publicly traded companies is $2.10 MBA 6101 Financial Accounting

  16. Margin vs. Turnover MBA 6101 Financial Accounting

  17. Non-operating Return Component of ROE • Assume that a company has $1,000 in average assets for the current year in which it earns a 20% RNOA. It finances those assets entirely with equity investment (no debt). • Its ROE is computed as follows: MBA 6101 Financial Accounting

  18. Effect of Financial Leverage • Next, assume that this company borrows $500 at 7% interest and uses those funds to acquire additional assets yielding the same operating return. • Its average assets for the year now total $1,500 and its profit is $265. MBA 6101 Financial Accounting

  19. Effect of Financial Leverage on ROE • We see that this company has increased its profit to $265 (up from $200) with the addition of debt, and its ROE is now 26.5% ($265/$1,000). • The reason for the increased ROE is that the company borrowed $500 at 7% and invested those funds in assets earning 20%. • The difference of 13% accrues to shareholders. MBA 6101 Financial Accounting

  20. MBA 6101 Financial Accounting

  21. GAAP Limitations of Ratio analysis • Measurability. Financial statements reflect what can be reliably measured. This results in non-recognition of certain assets, often internally developed assets, the very assets that are most likely to confer a competitive advantage and create value. Examples are brand name, a superior management team, employee skills, and a reliable supply chain. • Non-capitalized costs. Related to the concept of measurability is the expensing of costs relating to “assets” that cannot be identified with enough precision to warrant capitalization. Examples are brand equity costs from advertising and other promotional activities, and research and development costs relating to future products. • Historical costs. Assets and liabilities are usually recorded at original acquisition or issuance costs. Subsequent increases in value are not recorded until realized, and declines in value are only recognized if deemed permanent. MBA 6101 Financial Accounting

  22. Special Topics – Discontinued Operations • Discontinued operations are subsidiaries or business segments that the board of directors has formally decided to divest. • Companies must report discontinued operations on a separate line, below income from continuing operations. • The net assets of discontinued operations should be considered to be non-operating (they represent an investment once they have been classified as discontinued) and their after-tax profit (loss) should be treated as non-operating as well. • Although the ROE computation is unaffected, the non-operating portion of that return will include the contribution of discontinued operations. MBA 6101 Financial Accounting

  23. Special Topics – Preferred Stock • The ROE formula takes the perspective of the common shareholder in that it relates the income available to pay common dividends to the average common shareholder investment. • Thus, the presence of preferred stock requires two adjustments to the ROE formula (called ROCE). • Preferred dividends must be subtracted from net income in the numerator. • Preferred stock must be subtracted from stockholders’ equity in the denominator. MBA 6101 Financial Accounting

  24. Liquidity and Solvency Measures • Liquidity refers to cash: how much we have, how much is expected, and how much can be raised on short notice. • Solvency refers to the ability to meet obligations; primarily obligations to creditors, including lessors. MBA 6101 Financial Accounting

  25. Current Ratio • Current assetsare those assets that a company expects to convert into cash within the next operating cycle, which is typically a year. • Current liabilitiesare those liabilities that come due within the next year. • An excess of current assets over current liabilities (Current assets Current liabilities), is known as net working capitalor simply working capital. MBA 6101 Financial Accounting

  26. Quick Ratio • The quick ratio focuses on quick assets. • Quick assets include cash, marketable securities, and accounts receivable; they exclude inventories and prepaid assets. MBA 6101 Financial Accounting

  27. Solvency Ratios • Solvency refers to a company’s ability to meet its debt obligations. • Solvency is crucial since an insolvent company is a failed company. • Two common solvency ratios: MBA 6101 Financial Accounting

  28. Vertical and Horizontal Analysis MBA 6101 Financial Accounting

  29. Vertical and Horizontal Analysis MBA 6101 Financial Accounting

  30. DuPont Disaggregation Analysis • Profit margin is the amount of profit that the company earns from each dollar of sales. • Asset turnover is a productivity measure that reflects the volume of sales that a company generates from each dollar invested in assets. • Financial leverage measures the degree to which the company finances its assets with debt rather than equity. MBA 6101 Financial Accounting

  31. Return on Assets MBA 6101 Financial Accounting

  32. Return on Assets Adjustment The adjusted numerator better reflects the company’s operating profit as it measures return on assets exclusive of financing costs (independent of the capital structure decision). MBA 6101 Financial Accounting

  33. Return on Common Equity Adjustment MBA 6101 Financial Accounting

  34. DuPont Disaggregation for General Mills MBA 6101 Financial Accounting

  35. Chapter 4: Summary The separation of operating and non-operating portions of the balance sheet and income statements provides valuable insights into the financial results of a company Financial Ratios provide tools to evaluate the profitability, asset utilization, liquidity and solvency of a firm Common size techniques assist in analyzing trends and comparing firms Decomposition is a handy tool to determine answers to “why” certain results occurred. MBA 6101 Financial Accounting

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